UNITED STATES TAX COURT
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T.C. Memo. 2017-203
UNITED STATES TAX COURT
JEFFREY WYCOFF AND MERRIE PISANNO-WYCOFF, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24158-09.
Filed October 16, 2017.
Steven R. Toscher and Lacey E. Strachan, for petitioners.
Halvor R. Melom, Debra Ann Bowe, and Michael E. Washburn, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Chief Judge: Respondent determined deficiencies in petitioners'
Federal income tax and section 6662(a)¹ accuracy-related penalties as follows:
¹Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code), as amended and in effect for the years at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure. All monetary
(continued...)
SERVED Oct 16 2017
-2[*2]
Year
Deficiency
Penalty
sec. 6662(a)
2001
2002
$4,511,398
518,138
$902,280
103,628
After concessions,2 the issues for decision are (1) whether two subchapter S
corporations petitioners owned, Sirius Products, Inc. (Sirius), and Restore 4, Inc.
(Restore 4),3 are entitled to deduct management fees they paid to Albion
Management, Inc. (Albion), in 2001-034 (years at issue), and (2) whether
petitioners are liable for accuracy-related penalties pursuant to section 6662(a) for
the 2001 and 2002 taxable years.
¹(...continued)
amounts have been rounded to the nearest dollar.
2Respondent concedes that petitioners did not receive a deemed distribution
of their vested account balances in an employee stock ownership plan (ESOP)
trust under sec. 409(p)(2) in 2002. Petitioners concede that they were not entitled
to apply a net operating loss (NOL) generated in 2004 against their 2005 tax
liability, and they agree that the NOL should be applied against petitioners' 2002
tax liability. All other issues are computational.
3We will refer to Sirius and Restore 4 collectively as the operating
companies.
4Although respondent did not determine a deficiency in petitioners' 2003
Federal income tax, our determination of whether the operating companies are
able to deduct management fees paid to Albion in 2003 will affect the amount of
an NOL carryback that petitioners' claimed on their 2001 return.
-3[*3]
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulations of facts are
incorporated herein by this reference. Petitioners resided in Colorado when they
petitioned this Court. The parties have stipulated that an appeal in this case would
lie to the U.S. Court of Appeals for the Tenth Circuit.
I.
Background
Jeffrey Wycoff earned a bachelor of arts degree from Ryder College in
1975. Mr. Wycoff previously had two California State licenses: a B1 contractor's
license and a C54 tile contractor sublicense. In 1981 he sold life insurance. At
some point between 1981 and 1985 he managed a Domino's Pizza franchise.
From 1985 to 1991 he sold cars. From 1991 to 1995 he managed the Better Bath
of L.A. (later named Tile Pros), a construction company.
Merrie Pisanno-Wycoff earned her bachelor of arts degree in public
relations from California State University, Chico, in 1980 and her doctor of
philosophy degree in comparative religion from the University of Sedona.
II.
M
In the early 1990s petitioners asked a chemist, Dr. Marantz, to create a
chemical formula for a product that would clean tile. Dr. Marantz developed the
formula, and petitioners named the product "Zap". Petitioners filed a trademark
-4[*4] application for the name "Zap". They also attempted to patent the formula
but were advised by legal counsel that it was too simple to patent. They
subsequently decided to sell Zap using a direct response marketing model,
specifically infomercials. They had previously used direct response marketing for
other products, but the marketing for many of those products was not successful.
In their experience, whether the consumer liked the product was the most
important factor in determining success. They generally expected their products to
at best have an 18-month life cycle.
III.
The Operating Companies
A.
Sirius
Petitioners incorporated Sirius on January 11, 1995. They initially
capitalized Sirius with funds from Tile Pros and personal credit cards. They were
the only members of Sirius' board of directors and its only officers.
Sirius formulated, manufactured, and marketed household chemical
products. In particular, Sirius sold Zap directly to consumers using infomercials
and to various retailers, including Wal-Mart, Costco, Bed Bath & Beyond, Linens
'N Things, Walgreens, Target, Kroger, BJ's, Sam's Club, and several grocery
stores in Salt Lake City, Utah. Sirius also sold products that it developed, which
were unrelated to Zap. Sirius used direct response marketing, specifically "short
-5[*5] form" television advertisements (approximately two minutes long), to market
its products.
B.
Restore 4
Petitioners incorporated Restore 4 on January 30, 1997. They initially
capitalized Restore 4 with funds from Sirius. Restore 4 sold the same products as
Sirius. They incorporated Restore 4 because Sirius could not market its products
using the various direct response companies, such as the Home Shopping Network
and QVC. The operating companies operated out of the same facility, and they
shared a common labor force.
Restore 4 sold Zap under the name "Restore 4" (Restore 4 product).
Restore 4 owned the rights to the Restore 4 product name. Restore 4 sold the
Restore 4 product directly to consumers and through Home Depot. Restore 4
marketed its products via "long form" television advertisements (approximately 30
minutes long) and on QVC.
C.
The Operating Companies' Operations
On January 1, 2001, Sirius and Restore 4 elected to be subchapter S
corporations, and they were subchapter S corporations at all times during 2001-03.
Petitioners were at all relevant times the sole officers and board members of the
operating companies. After the years at issue Restore 4 merged with Sirius.
-6[*6] Mr. Wycoff was primarily responsible for all operations of the operating
companies. His principal duties included: negotiatmg contracts, overseemg
advertising purchases and content, managing the operating companies' finances,
selling the products to retailers, and overseeing other employees' work. In short,
Mr. Wycoff performed all managerial tasks for the operating companies. He also
referred to himself as the national sales manager and product spokesman because
of his duties in selling the products and overseeing advertisements.
IV.
The Marshall & Stevens Transaction
On August 18, 2000, Robert Boespflug of Marshall & Stevens ESOP5
Capital Strategies Group (Marshall & Stevens) gave a presentation to Barry
Marlin, petitioners' attorney at the time. The presentation outlined how the
operating companies and petitioners could purportedly reduce their income tax
liabilities by way of a series of transactions (collectively, Marshall & Stevens
transaction) using a subchapter S corporation, a deferred compensation plan, and
an ESOP. Petitioners did not attend this presentation. During the presentation Mr.
Boespflug's PowerPoint slides represented that the objectives of the Marshall &
Stevens transaction were to: (1) "reduce corporate income tax liability"; (2) "defer
income/reduce personal income tax liability of owners"; (3) "get equity
5ESOP is an abbreviation for employee stock ownership plan.
-7[*7] ownership/special benefits in the hands of key people"; (4) "provide
broad-based incentives to rank & file"; and (5) "create tax advantaged structure in
preparation of future asset sale". Marshall & Stevens' PowerPoint slides also
represented that the proposed steps of the transaction were as follows:
Step One: Form a new subchapter S Corporation (SMC);
Step Two: Create deferred compensation benefits for key employees
of operating entities;
Step Three: Adopt ESOP/401(k) plan;
Step Four: Sell new SMC stock to ESOP/401(k) for $1000
promissory note;
Step Five: Pay management fee from each operating entity to SMC.
Adopt mgt. contracts;
Step Six: Manage the new assets in the SMC, fund the deferred
compensation benefits and ESOP/401(k) Plans.
-8[*8] After the presentation Mr. Marlin and Roland Attenborough,6 an attorney
with Reish & Luftman hired by Marshall & Stevens to develop the portion of the
Marshall & Stevens transaction with respect to the ESOP, met with Mr. Wycoff to
discuss the transaction. After the meeting Mr. Wycoff instructed Mr. Marlin to
review the transaction. Mr. Marlin's review consisted solely of discussions with
two accounting firms. Mr. Marlin did not provide petitioners with a written legal
opinion. On the basis of Mr. Marlin's limited review petitioners decided to
implement the transaction, and on August 28, 2000, petitioners, on behalf of
Sirius, executed a contract with Marshall & Stevens to implement the Marshall &
6Trial was held in this case on August 13 and 14, 2012. During the course
of posttrial proceedings the Court became aware of a potential conflict of interest
involving petitioners' then counsel, Jeffrey D. Davine, an attorney associated with
Mitchell Silberberg & Knupp, LLP. At the time of trial Mr. Attenborough was
and had been, since before the filing of the petition, an attorney also associated
with Mitchell Silberberg & Knupp, LLP. After discussing the matter with the
parties the Court gave petitioners' counsel time to resolve the potential conflict of
interest by obtaining the informed consent of petitioners to counsel's continuing
representation. After consultation with independent counsel petitioners advised
their counsel and the Court that they would not provide the requested waiver.
Consequently, petitioners' former counsel withdrew his representation and new
counsel entered an appearance for petitioners. In an order dated January 4, 2014,
we concluded that petitioners' former counsel had an imputed conflict of interest,
and we reopened the record for petitioners to, inter alia, present evidence as to the
reasonableness under sec. 162 of the management fee and the arm's-length value
of the management services that Albion purportedly provided to the operating
companies.
-9[*9] Stevens transaction for a fee of $50,000. The contract contained the
following disclaimer:
The parties acknowledge that the S Management corporation and
KSOP strategy is an aggressive tax planning program and that the
CLIENT has been advised of this fact, has been advised to and has
had the opportunity to seek independent legal and tax counsel with
respect thereto, and does hereby accept the risk that the IRS may
challenge and/or disqualify any aspect of the program * * * .l7]
V.
Implemention of the Marshall & Stevens Transaction
A.
Step 1: Albion Management
On October 19, 2000, Mr. Attenborough incorporated Albion Management,
Inc. (Albion), and appointed petitioners as Albion's directors. Albion then
designated Mr. Wycoff as its president, Dr. Pisanno-Wycoff as its secretary, and
Janie Emaus as its chief financial officer. Petitioners have held their positions
with Albion ever since. Albion then issued 10,000 shares of stock and sold 2,500
of those shares to Mr. Wycoff for $250 and 7,500 of those shares to Dr. PisannoWycoff for $750. Albion also elected to be taxed as a subchapter S corporation.
B.
Step 2: Deferred Compensation Benefits
On November 1, 2000, Albion hired Mr. Marlin as its in-house counsel and
Mr. Wycoff as a full-time manager for Albion's clients. Mr. Wycoff's contract
7An ESOP that is combined with a sec. 401(k) plan is referred to as a KSOP.
- 10 [*10] with Albion provided that Albion would compensate him with an annual
salary, a deferred compensation plan, a life insurance policy, and an option to
purchase 100 shares of Albion's stock at any time.
On November 1, 2000, Albion also established a "Supplemental Retirement
Plan and Rabbi Trust" (Rabbi Trust).8 The Rabbi Trust was an unfunded deferred
compensation plan for the sole benefit of Mr. Wycoff. Mr. Wycoff is, and always
was, the sole beneficiary of the Rabbi Trust. Mr. Marlin was appointed as the
trustee of the Rabbi Trust. The Rabbi Trust agreement specified that it was
effective from November 1, 2000, either until Mr. Wycoff left the company or
until petitioners lost control of the company.
Under the Rabbi Trust agreement and Mr. Wycoff's employment contract
all contributions to the Rabbi Trust were at Albion's discretion and were to be
capped at 80% of Albion's management fees. The Rabbi Trust agreement forbade
the assignment, alienation, pledge, or encumbrance of funds in the Rabbi Trust.
8A rabbi trust is an unfunded deferred compensation plan. Funds deposited
into the trust remain subject to the claims of the employer's creditors. See In re IT
Group, Inc., 448 F.3d 661, 664-665 (3d Cir. 2006). The employee beneficiary of
the rabbi trust is not taxed on the funds deposited into the account until the funds
are actually distributed to him. See 4 Likewise, the employer is not entitled to a
deduction for the funds deposited into the rabbi trust until the rabbi trust actually
distributes the contributions. See id. at 665. Because Albion was an ESOP, a taxexempt entity, it had no need for a current deduction because its income was taxexempt. See secs. 401(a), 501(a).
- 11 [*11] The Rabbi Trust agreement provided that distribution of benefits was to
occur upon Mr. Wycoff's separation from service.
C.
Step 3: KSOP and ESOP Trust
On November 8, 2000, Albion established a combined employee stock
ownership and section 401(k) plan (KSOP) and an employee stock ownership plan
trust (ESOP trust). Albion appointed petitioners as trustees of the KSOP and the
ESOP trust. The operating companies then agreed to participate in the KSOP and
the ESOP trust. Petitioners did not participate in the KSOP or the ESOP trust.
D.
Step 4: Sell Albion to the ESOP Trust
On November 8, 2000, Albion contributed $1,000 to the ESOP trust.
Petitioners then sold all 10,000 shares of Albion's stock to the ESOP trust for
$1,000. On December 19, 2000, Marshall & Stevens determined that the book
value of Albion as of November 1, 2000, was $1,000.
E.
Step 5: Adopt Management Contracts
On October 30, 2000, the operating companies entered into management
agreements with Albion.9 The agreements did not specify the particular services
9Albion entered into two other management agreements with Soapworks
and Safety Tubs, two companies that petitioners incorporated in 2003. However,
because respondent does not challenge the management fees that Soapworks and
Safety Tubs paid to Albion, we do not discuss them.
- 12 [*12] that Albion employees would provide. Under these agreements the
operating companies agreed to purchase management services from Albion for
20% of their respective gross receipts.
To determine the management fee, Mr. Marlin, Mr. Attenborough, Mr.
Boespflug, and Mr. Wycoff held a meeting where Mr. Wycoff described the
services that Albion would provide to the operating companies. Petitioners did
not hire an adviser familiar with petitioners' business model to assist with
determining the amount of the management fee or to advise with respect to
reasonable compensation. Mr. Marlin, Mr. Attenborough, Mr. Boespflug, and Mr.
Wycoff had no experience determining reasonable compensation. On the basis of
Mr. Wycoff's information, however, Mr. Marlin, Mr. Attenborough, and Mr.
Boespflug calculated that an appropriate management fee was 20% of the
operating companies' gross receipts.¹°
On November 1, 2000, Albion hired Mr. Wycoff to "provide management
services to the client companies of * * * [Albion] so as to fulfill the obligations of
¹°Mr. Attenborough testified that the management fee was supported by
caselaw because courts had upheld similar management fees. Petitioners did not
introduce documentary evidence to show exactly how the management fee was
calculated, and the record does not reveal the cases Mr. Attenborough allegedly
reviewed or relied on. According to Mr. Wycoff the management fees were
calculated partially on the basis of the profitability of the operating companies and
not on the hours worked or services Albion provided.
- 13 [*13] * * * [Albion] under its various management agreements". The contract
between Albion and Mr. Wycoff did not specify the particular "management
services" that Mr. Wycoff was to provide. However, Mr. Wycoff provided the
same services to the operating companies that he had provided to them before
incorporating Albion.
The operating companies' functions did not change after they had hired
Albion except that the employees of the operating companies began providing
services via Albion. Employees were not aware of this change until they began
receiving their salaries from Albion. For all practical purposes, the operating
companies' employees' work did not change when they began working for Albion.
On January 1, 2002, the operating companies and Albion amended their
respective management agreements to provide that the operating companies would
pay Albion 10% of their respective gross receipts for Albion's services because
the operating companies' revenues had declined. On September 1, 2003, the
operating companies and Albion further amended their respective management
agreements to provide that the operating companies would pay Albion 3% of their
respective gross receipts for Albion's services. Regardless of the size of the fee,
Albion purportedly provided the same services to the operating companies for the
years at issue.
- 14 [*14] On their applicable Federal income tax returns the operating companies
reported the following gross receipts, total income or loss, management fees, and
ordinary or taxable income or loss:
Sirius
Yeg Gross receipts
Total income
Management fees
Income or loss
1998
1999
2000
2001
2002
2003
$4,944,211
2,227,397
16,164,535
30,974,978
7,831,765
1,535,736
----$1,094,393
8,413,486
1,236,198
328,075
($42,608)
-060,029
1,491,607
(482,847)
(298,568)
$7,004,350
8,068,096
23,268,263
46,475,388
18,648,288
4,336,682
Restore 4
Yeg Gross receipts
Total income
Management fees
Income or loss
1998
1999
2000
2001
2002
2003
$234,107
5,608,958
16,022,402
10,540,527
6,619,430
3,642,867
----$762,925
2,536,815
322,449
332,531
$25,398
48,965
426,274
(455)
139,054
(108,230)
$360,660
6,898,330
19,038,397
12,858,998
9,522,677
5,453,891
- 15 [*15] F.
Step 6: Fund Deferred Compensation
Albion's financial statements for financial year ending (FYE) December 31,
2001, FYE December 31, 2002, nine months ending September 30, 2003, and
three months ending (3ME) December 31, 2003, show the following Rabbi Trust
assets, accrued deferred compensation liability, and deferred compensation
expense:
Rabbi Trust assets
Accrued deferred
compensation
liability
Deferred
compensation
expense
Dec. 31, 2001 Not separately stated
Dec. 31, 2002
$4,651,269
Sept. 30, 2003
9,317,751
Dec. 31, 2003
¹10,739,301
$11,045,932
11,500,262
11,381,215
212,136,356
$8,760,242
774,954
548,740
87,355
F_Y_E
¹This amount was listed on Albion's balance sheet as follows:
Rabbi Trust
UBS-Rabbi Trust (f.k.a.)
Paine Web)
$1,032,883
9,706,418
2Albion accrued deferred compensation liability in its short, 3ME
Dec. 31, 2003, year even though its employment agreement with Mr.
Wycoff, as amended on Mar. 5, 2004, stated that such accruals would
cease on Sept. 1, 2003.
The Rabbi Trust's ledger does not reflect any contributions by Albion to the
Rabbi Trust. Instead, the Rabbi Trust's ledger reflects a series of contributions
from the operating companies on September 29, 2003.
- 16 [*16] On its Forms 1120S, U.S. Income Tax Return for an S Corporation, for
2001-03 and on the attached Schedules L, Balance Sheets per Books, Albion
reported the following gross receipts, investments in the Rabbi Trust, total assets,
and total liabilities and shareholders' equity:
T_Y_E
Gross
receipts
Assets
invested in
Rabbi Trust
Total assets
Total liabilities
and shareholders'
equity
Dec. 31, 2001
Dec. 31, 2002
Sept. 30, 2003
Dec. 31, 2003
$10,283,449
1,803,671
685,925
109,193
$10,787,657
11,294,169
(¹)
(¹)
$10,891,076
12,073,165
12,140,641
12,801,680
$10,891,076
12,073,165
12,140,641
12,801,680
¹For its taxable years ending Sept. 30 and Dec. 31, 2003,
Albion did not separately report its investments in the Rabbi Trust.
VI.
Windup of the Marshall & Stevens Transaction
On September 29, 2003, Albion revoked its subchapter S election and
terminated the ESOP portion of the KSOP plan. On January 23, 2004, Marshall &
Stevens determined that the book value of Albion as of September 30, 2003, was
$112,390. On March 5, 2004, Albion and Mr. Wycoff amended Mr. Wycoff's
employment agreement with Albion. Mr. Wycoff agreed to provide the same
services as before, in exchange for a $60,000 annual salary, the accrued benefits in
the Rabbi Trust, and a commitment that Albion would amend the Rabbi Trust
agreement to provide that the Rabbi Trust would begin distributing its assets
- 17 [*17] quarterly. Albion amended the Rabbi Trust agreement to provide that the
Rabbi Trust would begin distributing its assets at Mr. Wycoff's discretion.
On April 12, 2004, the ESOP trust sold all of its Albion stock to Sirius for
$112,390. On March 25, 2005, Marshall & Stevens determined that the book
value of Albion as of April 12, 2004, was zero. In its March 25, 2005, appraisal,
Marshall & Stevens opined that Albion's stock was worthless as of April 12, 2004,
because Albion's total liabilities (most of the liabilities consisted of accrued
deferred compensation) exceeded the value of its assets. On March 29, 2005,
Albion distributed $105,163.16 to various employees as a final distribution from
the ESOP.
VII. Wages Paid to Mr. Wycoff and Other Employees
From 1998 to 2000 the operating companies issued Mr. Wycoff Forms W-2,
Wage and Tax Statement, showing the following wages:
- 18 [*18] Year
Sirius
Restore 4
1998
1999
2000
$355,000
320,000
620,000
-0$137,500
¹500,000
¹Restore 4 issued Mr. Wycoff a Form W-2 stating
that his wages were $500,000. However, Restore 4
reported on its Form 1120S for 2000 that Mr. Wycoff's
wages were $642,500. Mr. Wycoff reported his wage
income from Restore 4 as $142,500 on petitioners'
Federal income tax return for 2000. Consequently, we
use the Form W-2 amount.
From 2000 to 2003 Mr. Wycoff's total compensation from Albion was as
follows:
Year
Wages
Deferred
compensation
expense¹
2000
$53,125
-0-
$53,125
2001
2002
2003
744,983
479,500
51,000
$8,760,242
744,954
636,095
9,505,225
1,224,454
687,095
Total
¹Petitioners' records vary as to the exact deferred
compensation expenses. The Court uses the figures
reported on Albion's financial statements as deferred
compensation expenses.
- 19 [*19] From 2001 to 2003 Albion reported" the following wage expenses for its
employees:¹²
Y_ear
Wages Albion
paid, excluding
wages paid to
Mr. Wycoff
Wages Albion
paid to
Mr. Wycoff
Payroll taxes
Total wage
expenses
2001
2002
2003
$143,866
353,205
419,792
$744,983
479,500
51,000
$29,870
Not separately stated
38,745
$918,719
832,705
509,537
Chet Millard was the most highly paid employee of the operating companies
from 2001 to 2003 other than petitioners. Mr. Millard was paid total wages of
$169,280, $141,779, and $78,762 by Albion and the operating companies for
2001, 2002, and 2003, respectively.
VIII. Potential Sale of Operating Companies
In 2001 petitioners hired Barrington & Associates, an investment banking
firm, to solicit offers to buy the stock or assets of the operating companies. In
drafting a memorandum for potential buyers, Barrington & Associates reviewed
the operating companies' financial performance. To calculate the profitability of
"Some of the amounts reported on Forms W-2 issued to employees are
different from the wage expenses Albion deducted on its tax returns. For
consistency, we rely on the amounts on the Forms W-2.
¹²The operating companies also paid wages, exclusive of wages paid to Mr.
Wycoff, of $574,905, $450,218, and $97,363 for the years at issue, respectively.
- 20 [*20] the operating companies, Barrington & Associates excluded the
management fees paid to Albion because the management fees exceeded market
rate salaries. Barrington & Associates estimated that a market rate salary for all
shareholder compensation was $300,000 per year.
IX.
Expert Witnesses
A.
Respondent's Expert
Respondent submitted the expert report of Kenneth Nunes, a chartered
financial analyst. Mr. Nunes earned a master of science degree in mechanical
engineering from the University of California, Davis, in 1981, and he earned a
master's in business administration from the University of California, Los
Angeles, in 1985. He has over 25 years of experience advising companies on
financial, valuation, and dispute resolution issues. Since 1990 Mr. Nunes has
testified as a valuation expert in various Federal and State courts.
Mr. Nunes's report addressed two issues: (1) whether Mr. Wycoff's
compensation from Albion was reasonable and (2) whether the management fees
that Sirius, Restore 4, Safety Tubs, and Soapworks paid to Albion were arm'slength fees within the meaning of section 482.
- 21 [*21]
1.
Mr. Wycoff's Compensation
Mr. Nunes examined the condition of the operating companies, the market
for executive compensation in the industry and in the business community
generally, and Mr. Wycoff's relevant qualifications and attributes.
Mr. Nunes found that compensation is typically determined by industry,
firm size measured either by company value or revenue, and position. He
determined that Mr. Wycoff was acting as the chief executive officer (CEO) of the
operating companies. Therefore, to calculate the reasonable total value of
compensation for Mr. Wycoff, Mr. Nunes examined compensation paid to
individuals acting as the CEO of comparable companies.
Petitioners had identified the operating companies' primary business
activity as the production and sale of household chemicals. Therefore Mr. Nunes
determined that the operating companies' peer group was companies that had
reported financial information from 1999-2003 in the following Standard
Industrial Classification (SIC) codes: 2841 (soap, detergents, cleaning
preparations, perfumes, cosmetics); 2842 (speciality cleaning, polishing and
sanitation preparations), and 2844 (perfumes, cosmetics, and other toilet
preparations). After reviewing the financial data of the peer group companies he
excluded companies with less than $5 million and more than $200 million in
- 22 [*22] annual revenue because the total revenue of the operating companies ranged
between $10 million and $60 million. Mr. Nunes included companies with annual
revenue of $60 million to $200 million because doing so increased the number of
companies to which he could compare the operating companies and the additional
information helped him determine the upper limits of reasonable compensation.
He excluded companies that conducted unrelated activities such as software
companies and pharmaceutical drug companies. He ultimately identified seven
companies that he concluded were comparable to the operating companies (peer
group).
Mr. Nunes then compared the data for the peer group with data from a
broader group of 24 different companies to ensure that the peer group did not set
executive compensation at unreasonably low levels. All 24 companies had annual
revenue below $200 million and were not pharmaceutical companies. In
comparing executive compensation between the peer group and the broader group
of 24 companies, Mr. Nunes used only cash compensation. He did not include
stock option compensation because he determined that stock option compensation
was not used in the industry and was "a meaningful source of CEO compensation
only at larger companies." Mr. Nunes found that the peer group did not omit
highly compensated individuals but rather included some of the most highly
- 23 [*23] compensated executives of the broader group of 24 companies. He therefore
concluded that the peer group represented compensation in the industry.
Mr. Nunes then performed a regression analysis on the peer group data to
create an equation for the relationship between annual CEO compensation and a
company's annual revenue. The equation allowed him to input a particular annual
revenue and determine what a company would pay its CEO. He calculated that
companies of similar size in terms of annual revenue and in the operating
companies' industry would have paid a CEO baseline compensation of $929,000
in 2001 and $606,000 in 2002.
In 2003 the operating companies' revenues were lower than those of the
peer group, and therefore Mr. Nunes decided that using the equation for 2003 was
not appropriate. Instead he calculated that the operating companies would pay a
CEO baseline compensation of $109,000, which was the lowest salary a CEO in
the peer group received for 2003.¹³
After calculating baseline compensation, Mr. Nunes considered whether
baseline compensation should be increased to account for unique characteristics of
¹³The company that had the lowest CEO salary for 2003 also had the lowest
revenue of the peer group. The operating companies had revenue of less than $10
million in 2003. In 2003 the company with the lowest revenue had revenue of
approximately $20 million.
- 24 [*24] the operating companies and Mr. Wycoff. Mr. Nunes decided that a 20%
cost of living adjustment was appropriate because of the location of the operating
companies. He then determined that a 10% decrease in baseline salary for 2002
and 2003 was appropriate¹4 because of revenue declines and a 20% increase in
2001 was appropriate because the operating companies had performed well.¹5 He
found that Mr. Wycoff's tenure, experience, and education were typical of other
CEOs in the peer group and no adjustment for individual characteristics was
necessary. Mr. Nunes therefore concluded that the reasonable total compensation
for Mr. Wycoff's services was $1,338,000, $654,000, and $118,000 for 2001,
2002, and 2003, respectively.
2.
Arm's-Length Management Fee
Mr. Nunes next determined what an arm's-length management fee would be
for the years at issue. He reached his arm's-length calculation by first determining
whether the services Albion provided the operating companies were nonintegral or
¹'Petitioners have cited the events of September 11, 2001, as a reason for the
decline in sales during 2002 and 2003. Mr. Nunes' report concludes that the
economy was relatively stable for the years at issue with the exception of a brief
shock after September 11, 2001.
¹sMr. Nunes cites academic literature indicating that executive
compensation is positively correlated with relative profitability and changes in
share value.
- 25 [*25] integral services for the purposes of the applicable regulations. M sec.
1.482-2(b)(3), (b)(7)(ii), Income Tax Regs. Mr. Nunes determined that Albion's
services were integral, and the applicable regulations required that operating
companies pay a management fee that unrelated parties would pay for similar
services. See sec. 1.482-2(b)(3), Income Tax Regs.¹6
To determine an arm's-length charge for Albion's services, Mr. Nunes
researched companies comparable to Albion. He used companies that had annual
revenue between $5 million and $500 million and reported themselves as
"employment agencies", "help supply services", and "all other professional
services". He determined that these companies were similar to Albion because
Albion provided routine management services to the operating companies.¹7 Mr.
Nunes then excluded companies that did not have a retail focus, which led to the
exclusion of healthcare and IT services companies. He therefore determined that
eight public companies engaged in management and administrative services with
financial information reported during the years at issue were comparable to
Albion.
¹6Mr. Nunes' report states that for nonintegral services an arm's-length price
is deemed equal to all costs incurred. See sec. 1.482-2(b)(3), Income Tax Regs.
¹7Albion reported itself under "all other professional services".
- 26 [*26] Mr. Nunes used a cost markup method to determine the arm's-length
management fee. His approach required him to determine the operating profit
earned by comparable companies as a percentage of their total costs.¹8 Mr. Nunes
chose this method because Albion's costs were "readily observable and services
provided are of a routine nature." After analyzing the costs of the eight public
companies similar to Albion, he determined that the median cost markup was
4.6%, -0.5%, and -0.4%, respectively, for the years at issue.¹°
Mr. Nunes then calculated Albion's total expenses for each of the years at
issue by adding the amount of Mr. Wycoff's reasonable compensation that he had
determined, see supra part IX.A.1., and Albion's other reported expenses. After
applying the median cost markup of comparable companies to Albion's total
expenses, he determined that Albion was entitled to aggregate management fees of
¹ªThe regulations refer to this method as the comparable profits method
(CPM). See sec. 1.482-5, Income Tax Regs. Petitioners contend that Mr. Nunes
used the "cost of services plus method" described in sec. 1.482-9(e), Income Tax
Regs. However, we find that the record supports a finding that Mr. Nunes used
the comparable profits method because Mr. Nunes compared Albion's operating
profit to that of similar companies. M sec. 1.482-5, Income Tax Regs. The "cost
of services plus method" compares profit markup of the uncontrolled transaction
with the controlled transaction. See sec. 1.482-9(e)(1), Income Tax Regs.
¹9The median cost markup was negative for 2002 and 2003 because the
comparable group of companies that Mr. Nunes used had losses during those
years.
- 27 [*27] $1.725 million, $1.417 million, and $705,000, respectively, for the years at
issue. Albion provided services during the years at issue to Sirius, Restore 4,
Safety Tubs, and Soapworks. Because Albion did not maintain time logs for its
services to each of the companies,2° Mr. Nunes allocated the management fees on
the basis of relative costs incurred by the entities and determined the following
allocations:
Company
2001
2QQ2
2003
Sirius
Restore 4
Safety Tubs
Soapworks
Total
$1,346,000
379,000
----1,725,000
$939,000
478,000
----1,417,000
$266,000
324,000
35,000
80,000
705,000
Mr. Nunes next considered the combined results of the reasonable
compensation and the arm's-length management fee analysis. After allowing for a
deduction for an arm's-length management fee, he calculated that the operating
companies had a three-year average operating income margin of 4.9%. Because
the operating income margin was within the three-year average for the operating
companies' peer group, he considered his results reasonable.
2°Albion started providing services to Safety Tubs and Soapworks only in
2003. As Mr. Nunes noted in his report, emerging companies often require more
management time. However, without logs of the services Albion provided, Mr.
Nunes was unable to allocate the management fee on the basis of services
provided to each company.
- 28 [*28] B.
Petitioners' Experts
1.
Mr. Dupler
Petitioners submitted the expert report of Timothy Dupler. Mr. Dupler has
experience working with companies using direct response marketing. He does not
have any experience, training, or education in financial analysis or with the
valuation of management contracts or executive compensation.
Mr. Dupler determined that the 20% of gross receipts that Albion charged
the operating companies as a management fee was reasonable and customary for a
company using direct response marketing. He based his opinion on his previous
experience with companies using direct response marketing, and he did not cite
any corroborating sources, documents, or authorities in his report.
2.
Mr. Burns
Petitioner also submitted the expert report of Francis X. Burns, who is an
accredited senior appraiser in business valuation from the American Society of
Appraisers and who is certified as accredited in business appraisal review by the
Institute of Business Appraisers. Mr. Burns graduated from Stanford University in
1982 and earned a master of management degree in finance and economics from
Northwestern University in 1986. He has over 25 years of experience as an
economic consultant, including experience evaluating executive compensation in
- 29 [*29] the valuation of businesses, in commercial damages litigation, and in
determining the reasonableness of compensation under the Code. Mr. Burns has
testified previously as an expert witness for both the Government and taxpayers.
Mr. Burns first considered the management contract Albion entered into
with the operating companies. He noted that, on the basis of information available
in October 2000 when the contract was signed, scaling management fees to sales
was reasonable because all parties assumed some risk of the operating companies'
success. However, he did not find the fact that petitioners controlled the operating
companies and Albion relevant when concluding that the contract was reasonable.
Mr. Burns next looked at the services Albion provided with a focus on the
services Mr. Wycoff provided. He noted that Mr. Wycoff served in a variety of
roles for the operating companies, including: (1) CEO, (2) chief financial officer,
(3) chief operating officer, (4) national sales manager, and (5) spokesman for the
operatmg companies.
To determine a reasonable management fee for the services Albion provided
the operating companies, Mr. Burns used four methods. First, he looked to
companies he had determined were comparable to petitioners' operating
companies. His consideration of companies that classified themselves as cleaning
product companies and direct response industry companies with revenues similar
- 30 [*30] to those of the operating companies resulted in one company. Because he
found only one, he expanded the criteria to include companies that classified
themselves as "Chemical and Allied Products" companies, which included
pharmaceutical companies. The new criteria resulted in 17 companies that he
considered sufficiently similar to the operating companies. Of the 17 companies,
16 were pharmaceutical companies. None of the companies manufactured
cleaning products, and only two sold cleaning products. On the basis of the
salaries paid to the CEOs of this group and Mr. Wycoff's other work for the
operating companies, Mr. Burns determined that a management fee of 15.1%
would be reasonable.
Mr. Burns' next method of calculating a reasonable management fee was to
compare Albion's CEO compensation with that of consulting firms. He
considered hourly rates of CEO compensation of six consulting firms and found
that the average rate was $740 per hour. He then determined, on the basis of Mr.
Wycoff's statements, that Mr. Wycoff worked 13.5 hours per day, and therefore
determined that Mr. Wycoff was entitled to $3.5 million per year, or
approximately 15.9% of expected net sales.
Mr. Burns' third method for determining the management fee was to review
an executive compensation survey. He used survey data from companies in the
- 31 [*31] cleaning, polishing, and sanitary preparations field with annual revenue of
$22.5 million.2¹ After combing the "maximum reasonable [cash] compensation"
from the survey and the median figures for equity based compensation, he
determined that an appropriate management fee was 15.3% of revenue.
The final method Mr. Burns used to calculate the management fee was an
independent investor test. Mr. Burns' independent investor test required him to
calculate the median return on tangible net worth for companies purportedly
operating in the same industry as the operating companies. Using data from a
survey, he determined that the median return on tangible net worth for similar
companies was 8.3% to 14.4% over the years 1996 to 2001. The independent
investor test led him to conclude that the operating companies should pay a
management fee of 14%.22
Mr. Burns concluded on the basis of his four methods that it would have
been reasonable to pay Albion 15% to 16% of the operating companies' sales for
the years at issue. He also noted that Mr. Wycoff should be entitled to additional
2¹The survey data is not from the years at issue. The oldest data available
for cash compensation was 2004, and data for equity compensation was available
starting in 2007.
22Mr. Burns' report also notes that on the basis of projections from
Barrington Associates, a management fee between 17% and 20% would be
acceptable for 2001 and 2002.
- 32 [*32] compensation for his roles as national sales manager and product
spokesperson.
X.
Notice of Deficiency
Respondent issued a notice of deficiency to petitioners on July 15, 2009.
Respondent disallowed the following deductions for management fees that the
operating companies reported paying to Albion:
Company
20Q1
20Q2
2003
Sirius
Restore 4
$8,413,486
2,536,815
$1,214,003
321,564
$35,069
226,317
Petitioners timely petitioned this Court.
OPINION
I.
Burden of Proof
Generally, the Commissioner's determination of a deficiency is presumed
correct, and the taxpayer bears the burden of proving that the determination is
improper. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
However, if a taxpayer produces credible evidence23 with respect to any factual
23"Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the judicial presumption of
IRS correctness)." Higbee v. Commissioner, 116 T.C. 438, 442 (2001) (quoting
H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995).
- 33 [*33] issue relevant to ascertaining the taxpayer's liability for any tax imposed by
subtitle A or B of the Code and satisfies the requirements of section 7491(a)(2),
the burden of proof on any such issue shifts to the Commissioner. Sec.
7491(a)(1). Section 7491(a)(2) requires a taxpayer to demonstrate that he or she
(1) complied with the requirements under the Code to substantiate any item,
(2) maintained all records required under the Code, and (3) cooperated with
reasonable requests by the Secretary24 for witnesses, information, documents,
meetings, and interviews. See Higbee v. Commissioner, 116 T.C. 438, 440-441
(2001).
Petitioners contend that the notice of deficiency should no longer be
presumed correct. Petitioners contend that the expert reports by Mr. Dupler and
Mr. Burns are credible evidence or that respondent has through his own
concessions and expert reports established that his determination in the notice of
deficiency was erroneous because respondent's primary position entitles
petitioners to deduct some management fees, while the notice of deficiency
disallowed the deduction for all management fees.
24The term "Secretary" means the Secretary of the Treasury or his delegate.
Sec. 7701(a)(11)(B).
- 34 [*34] Petitioners rely on a series of cases from the U.S. Court of Appeals for the
Ninth Circuit holding that the Commissioner's adoption of a litigation position
that substantially deviates from the position in the notice of deficiency results in a
forfeiture of any presumption of correctness in the notice and places the burden of
proof as to factual matters on the Commissioner. See Estate of Mitchell v.
Commissioner, 250 F.3d 696 (9th Cir. 2001), aff'g in part, vacating in part and
remanding T.C. Memo. 1997-461; Estate of Simplot v. Commissioner, 249 F.3d
1191 (9th Cir. 2001), rev'g and remanding 112 T.C. 130 (1999); Morrissey v.
Commissioner, 243 F.3d 1145 (9th Cir. 2001), rev'g and remanding Estate of
Kaufman v. Commissioner, T.C. Memo. 1999-119. The parties have stipulated
that appeal in this case would lie to the U.S. Court of Appeals for the Tenth
Circuit, and therefore we are not bound by caselaw from the U.S. Court of Appeals
for the Ninth Circuit. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970),
a_f[d, 445 F.2d 985 (10th Cir. 1971).
Even if we were to follow the precedent of the U.S. Court of Appeals for the
Ninth Circuit, the notice of deficiency would not lose the presumption of
correctness. Although in the notice of deficiency respondent disallowed
petitioners' claimed deductions for management fees, on brief he allowed the
deductions to the extent petitioners proved that Albion had paid wages or payroll
- 35 [*35] taxes. When the Commissioner concedes certain facts or issues, the notice
of deficiency is still presumed correct. See U.S. Holding Co. v. Commissioner, 44
T.C. 323, 328 (1965). In any event, we reach our decision on the basis of the
preponderance of the evidence. See Knudsen v. Commissioner, 131 T.C. 185, 189
(2008).
II.
Management Fee Deductions
A.
The Parties' Positions
Respondent advances four arguments as to why petitioners' claimed
deductions for management fees that the operating companies paid to Albion
under the compensation agreement should be reduced. Respondent's primary
argument is that the operating companies did not substantiate the management fees
beyond the amounts that Albion reported paying for wages and for payroll taxes.
Alternatively respondent contends petitioners are entitled to deduct only the
portions of the management fees that are considered reasonable compensation.
S_e_e sec. 162(a)(1). Respondent also argues that the management fees should be
reallocated under section 482 or, to the extent the management fees constitute
unreasonable compensation, the transaction should be recharacterized as
distributions to petitioners. Petitioners contend that the inquiries under section
- 36 [*36] 162 and section 482 are substantially the same and that under either Code
provision they are entitled to deduct the management fees.
On brief respondent concedes that Albion is not a sham entity and should
not be disregarded.25 Respondent asks us to determine Mr. Wycoff's reasonable
compensation under section 162. However, the management fees that the
operating companies paid to Albion are before the Court and not Mr. Wycoff's
reasonable compensation. Because respondent concedes that Albion is not a sham
entity, we will focus our analysis on section 482 and the proper arm's-length
amounts of the management fees. Although a section 482 analysis may require us
to determine Albion's costs, including Mr. Wycoff's reasonable compensation,26
Albion is entitled to charge the operating companies an arm's-length price for its
services that may be higher than the salaries Albion paid.27
25In the notice of deficiency respondent determined as an alternative
position that Albion should be disregarded because it lacked a legitimate business
purpose and had no economic substance.
26We also find that the record provides an adequate basis to determine Mr.
Wycoff's reasonable compensation, and therefore we reject respondent's
substantiation argument. See Cohan v. Commissioner, 39 F.2d 540, 542-544 (2d
Cir. 1930).
27Additionally, the regulations under sec. 482 provide that an arm's-length
charge shall not be deemed equal to costs or deductions with respect to integral
services. See sec. 1.482-2(b)(7)(ii)(A), Income Tax Regs. Respondent concedes
(continued...)
- 37 [*37] B.
Section 482
"Section 482 was enacted to prevent tax evasion and ensure that taxpayers
clearly reflect income relating to transactions between controlled entities." Veritas
Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). This section
gives the Commissioner broad authority to allocate gross income, deductions,
credits, or allowances between two related corporations if the allocations are
necessary either to prevent evasion of tax or to clearly reflect the income of the
corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C.
149, 163 (1994).
To determine true taxable income, the standard to be applied in every case is
that of a taxpayer dealing at arm's-length with an uncontrolled taxpayer. Sec.
1.482-1(b)(1), Income Tax Regs. The arm's-length result of a controlled
transaction must be determined under the method that, under the facts and
circumstances, provides the most reliable measure of an arm's-length result. M.
para. (c)(1). In determining which of two or more available methods provides the
most reliable measure of an arm's-length result, the two primary factors to take
into account are the degree of comparability between the controlled taxpayer and
27(...continued)
that the services Albion provided the operating companies were integral.
- 38 [*38] any uncontrolled comparable and the quality of data and assumptions used
in the analysis. See sec. 1.482-1(c)(2), Income Tax Regs.
The parties dispute the best method for determining an arm's-length result.
Petitioners contend that we should accept Mr. Burns' analysis, which applies four
different methods that all reach a result of 15% to 16% of the operating
companies' revenues as a management fee. Respondent contends that the CPM
that Mr. Nunes applied is best method for reaching an arm's-length result because
data of comparable transactions was unavailable and Mr. Nunes' determination
ensured that Albion would receive the same profit or loss as companies providing
similar services. Accordingly, we must determine the most reliable method for
calculating an arm's-length management fee.28 We do so by analyzing the expert
reports.
1.
Expert Reports
Both parties introduced expert witness reports and additional testimony to
assist the Court in determining the management fee. Expert witnesses are
28For sec. 482 to apply, the operating companies and Albion must be
"owned or controlled directly or indirectly by the same interests". See sec. 482.
During the years at issue petitioners owned and controlled the operating
companies. Petitioners served as directors of Albion and as trustees of the KSOP
plan and the ESOP trust. Petitioners therefore controlled Albion. Accordingly
sec. 482 applies.
- 39 [*39] appropriate to help the Court understand an area requiring specialized
training, knowledge, or judgment. See Fed. R. Evid. 702; Snyder v.
Commissioner, 93 T.C. 529, 534 (1989). Nonetheless, the Court is not bound by
an expert's opinion, and we may either accept or reject expert testimony in the
exercise of sound judgment. Helvering v. Nat'l Grocery Co., 304 U.S. 282, 295
(1938); Parker v. Commissioner, 86 T.C. 547, 561-562 (1986). Furthermore, the
Court may be selective in determining what portions of an expert's opinion, if any,
to accept. Parker v. Commissioner, 86 T.C. at 562.
a.
Petitioners' Experts
Petitioners first submitted the expert report of Mr. Dupler. Mr. Dupler has
previously worked with companies that use direct response marketing, and, on the
basis of that experience he concluded that a management fee of20% was
reasonable for Albion to charge. Mr. Dupler did not provide any support for his
opinion other than his experience, and he did not cite any academic literature or
trade publications. He cited fee arrangements by a company that he had worked
for as support for his conclusion, but he did not have access to the fee arrangement
contracts. Additionally, the contracts were not from the years at issue, and we are
not convinced that these contracts represent current trends. Mr. Dupler also
admitted that the contracts had been modified several times. Accordingly, we
- 40 [*40] decline to accept Mr. Dupler's conclusions in his expert report because they
cannot be verified. See sec. 1.482-1(c)(2), Income Tax Regs.
Petitioners also submitted the expert report of Mr. Burns. Mr. Burns
calculated that the "market-based compensation for management serviced
provided by Mr. Wycoff through Albion would have been in the range of 15% to
16%". Mr. Burns also found that Mr. Wycoff may be entitled to additional
compensation for his role as national sales manager and products spokesman. To
support his conclusion, Mr. Burns used four different methods.
Mr. Burns' first method was to look at comparable companies and compare
the salaries of the CEOs. He selected 16 pharmaceutical companies as comparable
corporations. We disagree that pharmaceutical companies are comparable to the
operating companies. M id. subdiv. (i) (stating that as comparability increases,
inaccuracy is reduced). As Mr. Nunes stated in his rebuttal report, the
development cost of a drug is substantially more than the cost of developing a
household cleaner. Most drugs also have a longer life span and are generally
protected through a patent. In contrast, the product at issue here, Zap, was not
eligible for a patent. Also, as petitioners conceded, most products that are
marketed using direct response have an 18-month product life cycle. Further, the
development of drugs requires particular skills and expertise that were not
- 41 [*41] required for petitioners' business. There is no evidence to support the claim
that pharmaceutical companies are comparable to the operating companies other
than Mr. Burns' opinion, and we do not find that opinion to be credible. Mr.
Burns did not select any company that manufactures cleaning products, and he
included only two companies that distributed cleaning products as comparable to
the operating companies. Accordingly, we find this method unreliable.
Mr. Burns' next method for determining the management fee was to
calculate the fee as if Albion were a consulting firm. He considered the hourly
rate of CEO compensation of six consulting firms, and after calculating the
number of hours Mr. Wycoff worked, Mr. Burns determined that Albion was
entitled to 15.9% of net sales for a management fee. However, Mr. Burns' report
is devoid of any analysis of how these six consulting companies compare to
Albion and the services it provided. Additionally, Mr. Wycoff did not maintain
time logs of the work he performed and for which entity. Other than his
testimony, which we find exaggerated and not credible, there is no evidence in the
record to support Mr. Wycoff's hours.
Mr. Burns' third method for determining the management fee was to review
an executive compensation survey. Although the survey includes companies that
considered themselves cleaning, polishing, and sanitary preparations companies
- 42 [*42] with revenue of $22.5 million, Mr. Burns' report does not identify which
companies he included.29 Mr. Burns' fourth method for calculating the
management fee was an independent investor test, which included companies from
the same company classification as the executive survey. He determined that these
companies earned a median return on tangible net worth ranged from 8.3% to
14.4%. For the operating companies to earn a similar return, Mr. Burns'
detennined that a management fee of 14% was reasonable.
We find both Mr. Burns' executive survey compensation method and
independent investor method unreliable. Under both methods, Mr. Burns did not
identify the companies he used for these tests. We note that respondent's expert
also used data from various company classifications and found that some of the
companies in particular classifications were not comparable to the operating
companies. Petitioners have objected to the use of a company in this category that
Mr. Nunes included in his report, yet petitioners' expert report does not state what
companies were included in the survey or independent investor method. In short,
we decline to accept Mr. Burns' determination because the underlying data is not
2°Additionally, in calculating an acceptable management fee under the
survey method, Mr. Burns used the "maximum reasonable [cash] compensation"
from the survey. However, Mr. Burns' report is devoid of any analysis as to why
Albion would be entitled to the maximum figure.
- 43 [*43] available, and we are unable to conclude that the companies on which Mr.
Burns relied are comparable to the operating companies.
b.
Respondent's Expert
Respondent submitted the report of Mr. Nunes. Mr. Nunes determined that
an appropriate method for calculating an arm's-length management fee was a
markup of Albion's expenses, referred to as CPM. See sec. 1.482-5, Income Tax
Regs. Mr. Nunes' method required that, after determining Albion's costs, Mr.
Nunes multiply the costs by the median profit margin of a comparable group of
companies for the particular year at issue.
Mr. Nunes looked to the cost markup of companies that provided
management services to other companies. His research found eight public
companies that were comparable to Albion. After analyzing the eight comparable
companies, Mr. Nunes determined that the cost markups should be 4.6%, -0.5%,
and -0.4% for the years at issue, respectively. He next determined Albion's costs
by using Albion's reported expenses, subtracting that portion of the expenses Mr.
Nunes considered to be unreasonable compensation to Mr. Wycoff.
Petitioners contend that Mr. Nunes' analysis is unreliable because the
analysis relies on his determination that Mr. Wycoff was overcompensated.
Because Mr. Nunes determined that Mr. Wycoff's compensation was unreasonable
- 44 [*44] for the years at issue, he adjusted Albion's reported expenses before
conducting his cost markup analysis. Accordingly, we will address Mr. Nunes'
reasonable compensation analysis.
Section 162(a)(1) allows a taxpayer to deduct "a reasonable allowance for
salaries or other compensation for personal services actually rendered" as an
ordinary and necessary business expense. A taxpayer is entitled to a deduction for
compensation payments if the payments are reasonable in amount and in fact paid
purely for services. Sec. 1.162-7(a), Income Tax Regs. The question of whether
amounts paid to employees represent reasonable compensation for services
rendered is a question of fact that must be determined in the light of all the
evidence. Botany Worsted Mills v. United States, 278 U.S. 282, 289-290 (1929);
Perlmutter v. Commissioner, 373 F.2d 45, 47 (10th Cir. 1967), afg 44 T.C. 382
(1965); Estate of Wallace v. Commissioner, 95 T.C. 525, 553 (1990), a_Ed, 965
F.2d 1038 (11th Cir. 1992). Special scrutiny is given in situations where a
corporation is controlled by the employees to whom the compensation is paid
because there is a lack of arm's- length bargaining. Pepsi-Cola Bottling Co. v.
Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), affg 61 T.C. 564 (1974); M
K Veterinary Supply, Inc. v. Commissioner, T.C. Memo. 2013-84, at *10.
- 45 [*45] Section 1.162-7(b)(2), Income Tax Regs., provides that "the form or method
of fixing compensation is not decisive as to deductibility." Contingent
compensation agreements generally invite scrutiny as a possible distribution of
earnings, but this Court has upheld such agreements under appropriate
circumstances. See Auto. Inv. Dev., Inc. v. Commissioner, T.C. Memo. 1993-298.
If a contingent compensation agreement generates payments greater than the
amounts that would otherwise be reasonable, those payments are generally
deductible only if: (1) they are paid pursuant to a free bargain between the
employer and the individual; (2) the agreement is made before the services are
rendered; and (3) the payments are not influenced by any consideration on the part
of the employer other than that of securing the services of the individual on fair
and advantageous terms. Sec. 1.162-7(b)(2), Income Tax Regs. Where there is no
free bargain between the parties, the contingent compensation agreement is not
dispositive as to what is deductible under section 162. Rather the Court is free to
make its own determination of what is reasonable compensation. Pepsi-Cola
Bottling Co. v. Commissioner, 528 F.2d at 181-183; Hammond Lead Prods., Inc.
v. Commissioner, 425 F.2d 31, 33 (7th Cir. 1970), af[g T.C. Memo. 1969-14.
The U.S. Court of Appeals for the Tenth Circuit, to which an appeal in this
case would lie, applies nine factors to determine the reasonableness of
- 46 [*46] compensation, with no factor being determinative: (1) the employee's
qualifications; (2) the nature, extent and scope of the employee's work; (3) the size
and complexities of the business; (4) a comparison of salaries paid with the gross
income and net income; (5) the prevailing economic conditions; (6) a comparison
of salaries with distributions to shareholders; (7) the prevailing rates of
compensation for comparable positions in comparable concerns; (8) the salary
policy of the taxpayer as to all employees; and (9) in the case of small corporations
with a limited number of officers, the amount of compensation paid to the
particular employee in previous years. Pepsi-Cola Bottling Co. v. Commissioner,
528 F.2d at 179.
We do not undertake an exhaustive review of each factor to determine that
Mr. Wycoff's compensation was unreasonable. Mr. Wycoff had not previously
worked in retail or with companies that use direct response marketing. In fact, Mr.
Wycoff testified that he had to learn how direct response marketing worked, which
is why Mr. Nunes determined that no increase to baseline compensation was
warranted to account for Mr. Wycoff's characteristics.
The record also does not convince us that Mr. Wycoff's work was any more
complex or extensive than that of a typical executive. Mr. Wycoff did work
diligently for the operating companies and his other startups; however, he did not
- 47 [*47] maintain any records reflecting what he did and for which company.3°
Petitioners also appear to argue that multiple salaries should be aggregated to
account for Mr. Wycoff's multiple roles. This Court has consistently rejected that
argument. See Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. at 569;
Richlands Med. Ass'n v. Commissioner, T.C. Memo. 1990-660, aff'd without
published opinion, 953 F.2d 639 (4th Cir. 1992); Ken Miller Supply, Inc. v.
Commissioner, T.C. Memo. 1978-228.
Petitioners owned the operating companies. Shareholder executive
compensation in a closely held corporation that depletes most of a corporation's
value is generally unreasonable when the deductible salary expenses are a disguise
for nondeductible profit distributions. See Eberl's Claim Serv. v. Commissioner,
249 F.3d 994, 1000 (10th Cir. 2001), § T.C. Memo. 1999-211. In this case, the
management fee depleted most, if not all, of the operating companies' profits. The
management fee in turn was used primarily to pay Mr. Wycoff. For example,
approximately 87% of the management fee went to pay Mr. Wycoff's
compensation in 2001.
3°Petitioners' expert Mr. Burns noted that Mr. Wycoff claimed to work 15
hours a day, seven days a week, and 52 weeks a year with no vacation. Mr.
Wycoff did not maintain logs of his hours, and his testimony with respect to his
hours was vague. We do not find Mr. Wycoff's testimony credible with respect to
his hours.
- 48 [*48] Our conclusion that Mr. Wycoff's compensation was unreasonable for each
year at issue is bolstered by the fact that the investment bank that petitioners had
hired to advise them with respect to the potential sale of the operating companies
found that Mr. Wycoff was compensated in excess of market rates and his annual
compensation should be approximately $300,000. Mr. Wycoff's compensation,
including deferred compensation, was $9,505,225, $1,224,454, and $687,095 in
2001, 2002, and 2003, respectively. While Mr. Wycoff's duties remained constant
from prior years to the years at issue, Mr. Wycoff received a substantial increase in
compensation during the years at issue. Petitioners contend that a portion of Mr.
Wycoff's compensation was compensation for work completed before the years at
issue. See Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930) (holding that a
taxpayer may deduct compensation paid in the current year but for services
provided in prior years). However, the record is completely devoid of any
evidence proving that Mr. Wycoff was underpaid before the years at issue or what
would have constituted reasonable compensation for those years. Even if Mr.
Wycoff had been underpaid for years before the years at issue, the operating
companies should have paid Mr. Wycoff directly and not Albion. Albion was not
in existence before the years at issue and could not have provided services.
- 49 [*49] In summary, Mr. Wycoff's compensation was unreasonable and Mr. Nunes
correctly adjusted Mr. Wycoff's compensation before calculating an arm's-length
management fee. In calculating Mr. Wycoff's reasonable compensation, Mr.
Nunes analyzed executive compensation of companies engaged in selling cleaning
products and found that Mr. Wycoff's compensation was substantially more. Mr.
Nunes provided a list of companies and excluded companies that were dissimilar
either by product or revenue. We are not convinced that the operating companies'
activities were more complex than the companies that Mr. Nunes relied on because
the operating companies also sold cleaning products. Therefore, we find Mr.
Nunes' conclusions regarding Mr. Wycoff's reasonable compensation reliable.
Petitioners contend that, even if Mr. Nunes computed Albion's expenses
including Mr. Wycoff's compensation correctly, Mr. Nunes did not use
comparable companies. However, according to the management contract, Albion
was providing standard management services similar to those provided by the
companies that Mr. Nunes used in his analysis. Mr. Nunes' report lists the
comparable companies and describes the work each comparable company
performed. Similarly to Albion, these companies provided management and
consulting services to other companies. While the record is vague as to exactly
- 50 [*50] what Albion did and for whom, we accept Mr. Nunes' determination that
Albion provided routine management services.
Petitioners further contend that Mr. Nunes' determination is not reliable
because the cost markup was negative for 2002 and 2003. However, product sales
fell during 2002 and 2003. Petitioners claim that this decline was due to the
events of September 11, 2001. Petitioners also testified that a typical direct
response marketing is usually profitable for only 18 months. Assuming without
deciding that these statements are true, Albion should have expected to recognize
losses in 2002 and 2003. Albion signed a long-term management contract.
Petitioners' expert, Mr. Burns, stated that the contract was rational from an
economic perspective and that if Albion oversaw a decline in sales, its
compensation would be reduced. This ensured Albion was incentivized to grow
sales and that Albion would share the risks with the product companies. Further,
even after the management fees are adjusted to an arm's-length result for 2002 and
2003, the operating companies collectively recognized losses. Accordingly we
find it rational that Mr. Nunes concluded that after substantial declines in sales
Albion would recognize losses during 2002 and 2003.
Petitioners additionally contend that Mr. Nunes' reasonableness test, which
averaged the three-year operating margin to detennine whether his analysis was
- 51 [*51] consistent with an arm's-length result, was flawed because the test
minimized the operating margin from 2001, petitioners' most successful year. The
applicable regulations under section 482, however, provide that using multiyear
data depends on the method being applied and the issue being addressed. In
various circumstances multiyear data may be considered in determining an arm'slength result. See sec. 1.482-1(f)(2)(iii)(B), Income Tax Regs. These
circumstances include situations where complete and accurate data is available for
the taxable year under review, the taxpayer's industry is affected by business
cycles, or the product being examined is affected by a life cycle. See id. Data
from one or more years before or after the taxable year under review must
ordinarily be considered for purposes of applying the CPM. Id.
Mr. Nunes applied the CPM, which generally requires the use of data from
one or more years. Mr. Nunes had complete and accurate data available from the
operating companies' and Albion's records. Additionally, Mr. Nunes determined
and petitioners admitted that the operating companies were affected by
macroeconomic recession and the products sold had a defined life cycle.
Therefore, the use of multiyear data was appropriate.
-52[*52]
2.
Conclusion
Petitioners and their experts3¹ have other criticisms of Mr. Nunes' report.
We do not find merit in these arguments and do not discuss them. We conclude
that Mr. Nunes' determination was reasonable and produced the most reliable
measure of an arm's-length result under the facts and circumstances. M sec.
1.482-1(c)(2), Income Tax Regs. (determining the best method depends on the
comparability of the transaction (or taxpayer) and the quality of the data).
Accordingly, petitioners' operating companies are entitled to the following
deductions for management fees:
III.
Company
2001
Sirius
Restore 4
Total
$1,346,000
379,000
1,725,000
$939,000
478,000
1,417,000
$266,000
324,000
590,000
Section 6662(a) Penalties
Section 6662(a) and (b)(1) and (2) authorizes the Commissioner to impose a
20% penalty on an underpayment of tax that is attributable to (1) negligence or
disregard of rules or regulations or (2) any substantial understatement of income
tax. Only one section 6662 accuracy-related penalty may be imposed with respect
3¹This includes the rebuttal report of Mr. Wertlieb. However, we do not find
Mr. Wertlieb's report persuasive, and therefore we do not discuss it.
- 53 [*53] to any given portion of an underpayment. New Phoenix Sunrise Corp. v.
Commissioner, 132 T.C. 161, 187 (2009), aff d, 408 F. App'x 908 (6th Cir. 2010);
sec. 1.6662-2(c), Income Tax Regs.
The term "negligence" includes any failure to make a reasonable attempt to
comply with the provisions of the internal revenue laws, and the term "disregard"
includes any careless, reckless, or intentional disregard. Sec. 6662(c); sec. 1.66623(b)(1) and (2), Income Tax Regs. "'Negligence' also includes any failure by the
taxpayer to keep adequate books and records or to substantiate items properly."
Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules or regulations "is
'careless' if the taxpayer does not exercise reasonable diligence to determine the
correctness of a return position" and "is 'reckless' if the taxpayer makes little or
no effort to determine whether a rule or regulation exists, under circumstances
which demonstrate a substantial deviation from the standard of conduct that a
reasonable person would observe." Id. subpara. (2); see also Neely v.
Commissioner, 85 T.C. 934, 947 (1985). An understatement means the excess of
the amount of the tax required to be shown on the return over the amount of the
tax imposed which is shown on the return, reduced by any rebate. Sec.
6662(d)(2)(A). An understatement is substantial in the case of an individual if the
- 54 [*54] amount of the understatement for the taxable year exceeds the greater of
10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).
The accuracy-related penalty does not apply with respect to any portion of
the underpayment for which the taxpayer shows that there was reasonable cause
and that he or she acted in good faith. Sec. 6664(c)(1). The decision as to whether
a taxpayer acted with reasonable cause and in good faith is made on a case-by-case
basis, taking into account all of the pertinent facts and circumstances, including
the experience, knowledge, and education of the taxpayer. See sec. 1.66644(b)(1), Income Tax Regs. "Circumstances that may indicate reasonable cause and
good faith include an honest misunderstanding of fact or law that is reasonable in
light of all of the facts and circumstances, including the experience, knowledge,
and education of the taxpayer." Id. Reliance on the advice of a tax professional
may, but does not necessarily, establish reasonable cause and good faith for the
purpose of avoiding a section 6662(a) penalty. United States v. Boyle, 469 U.S.
241, 251 (1985). A taxpayer's reliance on a competent tax professional may
establish reasonable cause and good faith when the taxpayer provides necessary
and accurate information to the adviser and the taxpayer reasonably relies in good
faith on the adviser's judgment. See Neonatology Assocs., P.A. v. Commissioner,
115 T.C. 43, 99 (2000), afCd, 299 F.3d 221 (3d Cir. 2002).
- 55 [*55] The Commissioner bears the burden of production with respect to the
taxpayer's liability for the section 6662(a) penalty and must produce sufficient
evidence indicating that it is appropriate to impose the penalty. See sec. 7491(c);
Higbee v. Commissioner, 116 T.C. at 446-447. Once the Commissioner meets his
burden of production, the taxpayer must come forward with persuasive evidence
that the Commissioner's determination is incorrect or that the taxpayer had
reasonable cause or substantial authority for the position. See Higbee v.
Commissioner, 116 T.C. at 446-447.
Although the parties made concessions before the start of trial and on brief,
and the Court allowed the operating companies to partially deduct the management
fees paid to Albion, the computations under Rule 155 will establish that there is a
substantial understatement of income tax. Respondent has, therefore, satisfied his
burden of production to the extent that the accuracy-related penalty relates to a
substantial understatement of income tax.
Petitioners contend that they had reasonable cause and acted in good faith
because they reasonably relied on the advice of tax professionals with respect to
setting the management fee. Petitioners did not contend that they had reasonable
cause or acted in good faith with respect to the NOL. Therefore, with respect to
- 56 [*56] that portion of the underpayment, petitioners are liable for accuracy-related
penalties under section 6662(a).
We next address whether petitioners reasonably relied on the advice of tax
professionals with respect to setting the management fees paid to Albion.
Petitioners sought the advice of Marshall & Stevens ESOP Capital Strategies
Group, Barry Marlin, and Roland Attenborough to determine the proper
management fees that the operating companies should pay Albion. To determine
the management fees, petitioners' tax advisers met with Mr. Wycoff to understand
the services Albion would provide to the operating companies and researched
caselaw with respect to reasonable compensation. Petitioners were subsequently
advised to set the rate of the management fees at 20% of each operating
company's gross receipts.
Mr. Wycoff testified in great detail that companies using direct response
marketing compensate differently from other companies; however, petitioners still
relied on the advice of Marshall & Stevens, Mr. Marlin, and Mr. Attenborough to
determine the management fee. Both Mr. Attenborough and Marshall & Stevens
were experienced in forming ESOPs but were not experienced in determining an
arm's-length management fee. Petitioners also knew that Mr. Attenborough was
hired by Marshall & Stevens to complete the transaction and that Marshall &
- 57 [*57] Stevens had an economic interest in petitioners' going forward with the
transaction. Mr. Attenborough had an obvious conflict of interest that petitioners
and Mr. Marlin knew or should have known about. See Neonatology Assocs.,
P.A. v. Commissioner, 115 T.C. at 98-99. Additionally, aside from the work that
Mr. Marlin completed for petitioners, none of the advisers had experience with
companies using direct response marketing. Mr. Marlin's law practice focused on
international tax, and petitioners knew or should have known the planning at issue
here did not involve any international tax issue. Petitioners did not consult an
economist or any adviser with experience in determining an arm's-length
management fee to calculate the management fees the operating companies paid
Albion. Assuming that petitioners' claims are true regarding direct response
marketing, a prudent business person in Mr. Wycoff's situation with similar
experience, knowledge, and education would have sought the advice of an adviser
with experience in direct response marketing and/or calculating a reasonable
management fee. See sec. 1.6664-4(b)(1), Income Tax Regs. We are not
convinced petitioners reasonably relied on independent advisers who were
competent in calculating a reasonable management fee and/or executive
compensation. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99.
- 58 [*58] Neither did petitioners introduce any documentary evidence with respect
how the management fees were determined. Petitioners claim a document existed,
but they claimed they did not have it. See Wichita Terminal Elevator Co. v.
Commissioner, 6 T.C. 1158, 1165 (1946) (stating that a taxpayer's choosing not to
present evidence within his or her possession gives rise to a presumption that it
would have been unfavorable if it had). Petitioners' advisers testified only
vaguely regarding the determination of the management fees. The advisers
testified that the management fees were originally set at 20% of gross receipts
because, in caselaw they purportedly reviewed, unidentified courts had held that
percentage to be reasonable.32 The advisers also met with Mr. Wycoff to
understand the services he provides, but the record does not indicate whether Mr.
Wycoff provided all necessary and accurate information to petitioners' advisers.
Petitioners presented no credible evidence that their advisers considered what
32On brief petitioners contend that the Court erred in excluding testimony
from Frederick Thomas, president of Marshall & Stevens. Petitioners contend that
Mr. Thomas could offer testimony of Marshall & Stevens' general business
practices to prove that an analysis of a reasonable management fee would have
been completed as part of the Marshall & Stevens transaction. Petitioners' tax
advisers testified that an analysis was completed. Although petitioners' tax
advisers' description of the analysis is vague, we conclude that the testimony of
Mr. Thomas would not have been helpful to the Court. He has no personal
knowledge of this particular transaction, and other advisers with personal
knowledge did testify.
- 59 [*59] comparable companies would pay for comparable services when calculating
the management fees. Because the record is so vague as to how petitioners'
advisers calculated the management fees, we cannot find that it was reasonable to
rely on such an analysis.
Petitioners also knew that the Marshall & Stevens transaction was an
aggressive tax planning program. Petitioners were warned that there were risks
and were encouraged to seek independent counsel. Petitioners did not seek advice
from independent counsel and from advisers with the requisite experience. In
short, petitioners' reliance on their tax advisers, who were part of the promoter
group, was not reasonable. Accordingly, we sustain accuracy-related penalties
under section 6662(a).
We have considered the parties' remaining arguments, and to the extent not
discussed above, conclude those arguments are irrelevant, moot, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.